What’s holding back Janet Yellen?

Fed chair Janet Yellen’s speech at the Jackson Hole meeting and hawkish comments by vice chairman Stanley Fischer have boosted market expectations for a rate hike in the short term.

Now, will the US dollar stage another rally amid such expectations?

Latest Federal funds rate indicates that the chance for a rate hike this year has jumped to as high as 60 percent recently. That compares with a trough of zero to 10 percent between late June and early July.

Meanwhile, strong jobs data has further boosted the case for hiking interest rates.

Fischer believes “the Fed isn’t behind the curve”, but he admitted that the US job market is “very close to full employment”.

The Fed funds rate should be around 3.46 percent, according to the Taylor Rule, almost 300 basis points above the current level.

The record gap suggests that the Fed is indeed behind the curve.

So why has Yellen been hesitant about taking action? Well, there are two reasons.

First of all is the high leverage in the US economy.

American consumers and corporates have failed to deleverage after the 2008 financial crisis. Instead, they kept borrowing more over the last seven years due to ultra-low interest rates. The leverage level is at least the same or even higher than where it was before the financial crisis.

Fed, consumers, households, businesses and corporates have a combined outstanding debt of US$54.6 trillion, up US$13.3 trillion or 32 percent from that in late 2008. If Fed starts to normalize interest rate, the economy will face huge deleveraging pressure.

The US government’s interest expense, which has already climbed to a historical high of 470 billion dollars as of the second quarter, will rise further.

The US dollar has moved in tandem with Fed’s monetary easing since the 2008 financial crisis. The greenback posted strong rally after the central bank started tapering in early 2014, and the rise has lasted until early 2015.

Since then, the dollar index has been hovering in a strong range of 94 and 100 for most of the time, underpinned by monetary easing policies in Japan and Europe.

A strong dollar would hurt competitiveness of US exporters, as well as their earnings and even the overall economic performance.

It could possibly trigger financial market turmoil too. We’ve already seen that in particular in emerging markets.

The dollar index spiked over 25 percent to 100 from below 80 between mid-2014 and early 2015, leading to a plunge in commodity prices, on which many emerging economies depend. These economies often have large US dollar borrowings as well.

As a result, emerging economies are typically susceptible to capital outflows when the greenback shows significant strength.

Given the above considerations, any Fed tightening will be gradual, and the dollar index is unlikely to rise above 100 in the near term.

But if Fed nudges the rates steadily higher over the long run, while Europe and Japan keep easing, another round of dollar rally will eventually take place.

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